Academic journal article Management Accounting Quarterly

Does the Content of Pro Forma Earnings Influence Nonprofessional Investors?

Academic journal article Management Accounting Quarterly

Does the Content of Pro Forma Earnings Influence Nonprofessional Investors?

Article excerpt

Core earnings, street earnings, and adjusted earnings. Investors use these terms interchangeably in the market to refer to pro forma earnings. Pro forma earnings offer firms an alternative way to present earnings that are not in accordance with generally accepted accounting principles (GAAP) and, more importantly, exclude certain income statement and balance sheet items that are likely to increase earnings when compared to GAAP profitability metrics. These exclusions generally are items that are nonrecurring or are noncash items. Companies believe that when they exclude them from their earnings they report a better representation of the core business. The market has accepted the use of pro forma earnings, and investors often use it as the key financial metric when evaluating companies' performance and valuation.

Several high-profile companies have recently stretched the limit of pro forma earnings. That is, they have included additional exclusion items the market does not normally use. Not only did they exclude the normal items that the market has deemed appropriate, but they have also excluded other line items that do not clearly fall under the umbrella of being a nonrecurring expense or a noncash item. Several high-profile companies have practiced this phenomenon, making pro forma earnings a pressing and popular issue in the market.

Groupon, Inc., for example, filed with the U.S. Securities & Exchange Commission (SEC) in the fall of 2011. When the company released its financial statements, it provided pro forma earnings, which it referred to as adjusted consolidated segment operating income (adjusted CSOI). Groupon disclosed this information within its Form S-1 disclosure and described it as a metric that represents "an important measure of the performance of our business as it excludes expenses that are noncash or otherwise not indicative of future operating expenses." To calculate this number, Groupon excluded marketing expenses and acquisitionrelated spending, much of which involved customeracquisition costs. Investors should contrast this with more typical exclusions that qualify as a noncash item or a nonrecurring event.

Given Groupon's size, it is understandable that using these nonstandard exclusions in calculating non-GAAP performance metrics aroused the suspicion of analysts and investors. Herman Leung, a senior technology stock analyst with Susquehanna Financial, suggested that using adjusted CSOI within the Form S-1 represented a "lack of transparency for key metrics." The outcry over this metric was exacerbated by its impact on earnings, which transformed a GAAP loss into a nonGAAP profit through the selected exclusions. Studies show that only 13.5% of non-GAAP pro forma earnings announcements resulted in this type of shift.1 Although the SEC forced Groupon to refile its initial S-1 filing related to its initial public offering (IPO) due to concerns over the adjusted CSOI metric, the updated filing merely provided the following clarification: "While not a valuation metric, [adjusted CSOI] provides us with critical visibility into our business."2

The SEC also scrutinized Zynga's IPO over the use of bookings, a non-GAAP measure of revenue, to calculate pro forma earnings.3 The quality of pro forma exclusions, however, has improved since the introduction of Regulation G.4 (Regulation G requires companies providing non-GAAP earnings to reconcile these measures to the most comparable GAAP measure.) The recent high-profile disclosures of pro forma earnings containing potentially uncommon exclusions by Groupon and Zynga suggest that there remains a need to assess the ability of investors to identify potentially misleading exclusions in pro forma earnings calculations.5 These types of exclusions are of particular concern given the aforementioned changes in regulations governing IPO access for nonprofessional investors.

The problem with Regulation G is deciding what is and is not a misleading financial measure because this impacts companies and investors alike. …

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